Modern Portfolio Theory is Dead...?
At a recent luncheon, I watched the Chief Investment Officer of Northern Trust make arguments that seem all too common this year.
His main point was that using Modern Portfolio Theory (MPT) is "the old way of doing things" because in 2008, assets that should have zig-zagged independently all dropped last year. The implication, of course, is that diversification failed when it was needed most, and that asset allocation doesn't work.
I find this to be a typical gimmick to lure people (new customers) who got slaughtered by investment markets last year and are searching for better ways to invest their money. But allow me to pick apart their main arguments:
Their Point: Correlations are not stable and go to one (1) during a crisis; so regardless of whether you have real estate, international stocks, or small cap stocks, it will not do you any good.
My Counterpoint: Many studies show that this conclusion is not true. Work by Loretan & English as well as Kim & Finger and Ragea show that higher correlations are simply a result of higher volatility, not because of some "contagion" spreading across equity investments; that correlations apparently increase, but don't actually change.
If they really believed this claim, their portfolios would only include two assets, the market index (S&P 500) and US treasury bills; however, their sample portfolio included allocations to real estate and hedge funds.
Their Point: You should create a cash flow immunized portfolio to minimize the potential shortfall. In other words, treat your portfolio like a pension fund.
My Counterpoint: This strategy may be useful in many situations, but equally inappropriate in just as many others. If you knew with a high degree of confidence that the objectives, timing, and risk tolerance would not change over time, or with changes in market conditions, then you have a much better case with the immunization strategy. The reality is that life happens, goals shift, tax laws change, and among other things, people change.
Their Point: Diversificaton failed, MPT is dead.
My Counterpoint: Modern Portfolio Theory has long been abused by many practitioners; particularly by those who rely on mean-variance optimization software - as if mean returns and variance are the only important factors?! What does it say on all investment literature? Past performance is no indication or guarantee of future performance. Yet, many practitioners plug in historical return information into their software to finalize an asset allocation model: Garbage in, Garbage out.
In the end it's just a theory; so what happens in practice? When the father of MPT, Harry Markowitz, was asked how he would invest among stocks and bonds, instead of making intricate calculations, he replied, "My intention was to minimize my future regret... So I split my contributions 50/50 between bonds and equities."
Markowitz chose to minimize his regret instead of minimizing portfolio variance!